So today, I want to delve into the causes and consequences of the last major banking crisis — and why the current meltdown is similar. Then, I’m going to tell you what it means for our nation’s economy and your finances.

The Scary Parallels Between Then and Now

The original S&L crisis stemmed from several factors. Three of the most important ones:

#1. Interest rate gyrations caught many institutions borrowing money at high rates and lending at relatively low ones. This mismatch between borrowing and lending rates wreaked havoc on bank earnings and net worth.

#2. Banks overextended themselves in the commercial real estate sector. They made too many risky loans to too many high-risk borrowers, and when the economy slowed, losses surged. The oil price bust of the mid-1980s made a bad problem worse, helping wipe out scores of S&Ls in Texas.

#3. Weak regulation and disturbingly low capital levels made S&Ls vulnerable to failure.The use of brokered deposits — where S&Ls chased “hot money” depositors by offering high interest rates — caused its own set of problems.

Ultimately, more than 1,000 S&Ls failed, and the U.S. government was forced to step in with a bailout totaling an estimated $150 billion. It took years for the agency established to help resolve bad loans — the Resolution Trust Corporation — to finally work through the morass of impaired assets.

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These days, interest rates are still relatively low and banks are better capitalized than they were in the 1980s. That’s an important difference.

But this time around, the bubble in residential mortgage lending and the underlying housing industry was also much bigger — and much more widespread — than the commercial real estate boom was back then.

This time around, home prices surged much faster than incomes. Real estate speculation soared. Lending standards were flushed down the toilet.

Moreover, some of the most complex, hard-to-value, mortgage-related securities and derivatives ever invented were foisted on the financial markets. They were snapped up by eager investors who, it turns out, had no real idea what they were buying.

And now, the list of casualties is expanding by the day …

Banks, Brokers, and Insurers Are Losing Money Hand Over Fist, Fueling the Risk Of a Large-Scale “Credit Crunch”

A few weeks ago, I covered some of the biggest losers. I told you how Citigroup’s profits plunged 57% … Washington Mutual’s earnings tanked 72% … Bank of America took a $4 billion hit … while Merrill Lynch suffered a $7.9 billion whacking.

Since then, things have gotten WORSE, not better! Shares of the bond and mortgage insurance firms I told you about (Ambac Financial Group, MBIA, and the like) continue their swan dives amid fears over credit losses related to complex mortgage securities.

Meanwhile, the mortgage giants Fannie Mae and Freddie Mac are in freefall. Freddie Mac shares dropped as much as 35% on Tuesday, the biggest drop since it went public in 1988, while shares of Fannie Mae plunged the most since the 1987 stock market crash.

Why? They reported combined losses of $3.4 billion in the most recent quarter due to the plunging value of mortgage investments and the rapid increase in loan delinquencies and losses. Freddie Mac added that it will have to raise capital and announced that it will probably cut its dividend.

You can see why the estimates of the final fallout keep getting ratcheted higher and higher:

Egan-Jones Ratings went so far as to predict “massive losses” — $4.3 billion at Ambac … $7.25 billion at MGIC Investment … and up to $20.2 billion at MBIA.

Royal Bank of Scotland weighed in with a forecast of $100 billion in write-downs for banks and brokers loaded up with so-called “Level 3” assets. Those are assets whose value is essentially based on theoretical estimates, not actual market transactions.

Lehman Brothers was even more aggressive. It said the credit meltdown could ultimately cost firms $250 billion.

Deutsche Bank weighed in with a $300 billion to $400 billion estimate.

And fasten your seatbelts — the chief economist at Goldman Sachs said these huge losses could force lenders to cut lending activity by a whopping $2 trillion!

Why Should You Care About All These Losses Piling Up in the Financial Sector?

In a nutshell, if banks get hit with too many losses, their capital levels get impaired. They face increased oversight from federal regulators. And they get nervous and cut back on making new loans.

That’s what leads to a credit crunch — when even good borrowers can’t obtain car loans, or mortgages, or small business financing.

In fact, it’s already happening!

As Martin told you on Monday, lenders aren’t just tightening standards on subprime mortgages — they’re tightening them on prime mortgages as well. They’re getting stingier with commercial and industrial loans. And they’re clamping down on commercial real estate lending excesses.

Plus, if past is prologue, and this truly is an S&L-type credit crunch that’s brewing, here’s what you’re going to see:

More bank failures. These are just now starting to happen after a period of extraordinary calm where NO banks failed. So far in 2007, we’ve seen a pair of small banks in Pennsylvania and Ohio fail, as well as NetBank of Alpharetta, Georgia — an institution with $2.5 billion in assets.

But the number of “problem” institutions identified by the Federal Deposit Insurance Corp. (FDIC) climbed to 61 in the second quarter of this year from 53 a quarter earlier. Those firms had $23.1 billion in assets, up from $21.5 billion. That’s low by historical standards, but the direction — higher — is clear.

More write-downs on Wall Street. I’ve already told you about many of the biggest blowups. But it’s worth noting that other firms are suffering, too. For example, Morgan Stanley lost $3.7 billion in just two months this fall due to the falling price of home-loan related securities. And as I mentioned earlier, the estimates of future write-downs keep spiraling higher.

There’s another key risk: The ratings agencies like Moody’s and S&P may finally do their job and cut the official ratings on many of these junky securities that banks are lugging on their balance sheets. If they do, it could trigger more “forced selling” from investors and firms who can’t hold debt rated below certain levels.

If the S&L crisis is any guide, you can bet the total losses from the housing and mortgage crisis will keep rising. It’s just the nature of the beast. The farther home prices fall, and the longer the crisis drags on, the higher the losses will climb.

More government bailout proposals. No way, no how is Congress, the Federal Reserve, or the administration going to sit around and watch as the housing and mortgage markets implode. You’re going to see a full-court press!

The Federal Reserve is already slashing interest rates. It has cut the federal funds rate 75 basis points already, and another 25 or 50 points are probably on deck between now and early 2008.

Meanwhile, the Treasury Department has been trying to push a so-called “Super SIV” rescue fund. This idea is that the fund will buy up a bunch of crummy debt securities, including mortgage-related ones, from various smaller funds and banks and dump them into one place. That will prevent widespread selling of impaired debt and allow investment firms to avoid billions of dollars more in losses.

Federal Housing Administration reform is another approach the government is using to refinance borrowers out of toxic subprime loans. We’re also seeing regulators bring tons of pressure to bear on mortgage lenders and servicers. They want them to modify existing loans to stem the foreclosure wave.

More economic fallout. Look, if it was just a bunch of rich Wall Street bankers who were being forced to trade down from Bentleys to BMWs, none of us would have a reason to care about this crunch. But it’s not.

The spreading housing and mortgage meltdown is now slowing the REAL economy by hurting consumer confidence and causing job gains to slow. And that’s hurting corporate America.

Just look at the earnings warnings that are starting to flood the market:

Home improvement retailer Home Depot said sales fell for a second consecutive quarter, something that hasn’t happened since 1982. It cut its full-year profit forecast. And the company’s closest competitor, Lowe’s, also slashed its earnings target after third-quarter profit sank 10%.

The department store Kohl’s just reported its first quarterly profit decline in more than three years. It cut its earnings forecast, while competitor Macy’s did the same for its sales targets.

The broad economic data is souring, too. Jobless claims filings are the highest they’ve been since April … industrial production fell 0.5% in October … and holiday retail sales are on track to be the worst since 2002.

Second, protect yourself further by continuing to avoid vulnerable sectors of the market — home builders, lenders, construction suppliers, and the like.

Third, stick with contra-dollar investments like precious metals and foreign stocks and bonds. The Fed will be forced to keep monetary policy easy to cushion the pain of the housing crisis. That, in turn, should hurt the dollar.

Fourth, if you’re more aggressive, consider hedging your portfolio by shorting stocks in vulnerable sectors or by purchasing inverse ETFs.

Until next time,

Mike

P.S. Don’t forget to look for Jack’s next issue tomorrow. He’ll be bringing you the latest currency news every weekend from here on out!

Money and Markets(MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, Tony Sagami, and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Adam Shafer, Andrea Baumwald, Kristen Adams, Maryellen Murphy, Red Morgan, Jennifer Newman-Amos, Julie Trudeau, and Dinesh Kalera.

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